Higher Rates, Sure—But Not That High

August 14, 2014

As investors prepare for rising borrowing rates, many seem to be asking all the wrong questions.

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article features John Forlines III, chairman and chief investment officer of Long Island, N.Y.-based JAForlines Global.

Alexander Bickel, Yale law professor and Supreme Court critic, once commented: “No answer is what the wrong question begets.”

The wooly thinking that Bickel despised is on plain display these days in financial markets, with too many folks asking wrong-headed questions like, “When is the Fed going to raise rates?” and “Are the markets—equity or fixed income, pick one—overvalued?”

Forget those. We think there’s only one relevant question: “Why are the expected rate increases so low?”

The media-driven narrative about the timing of rate increases and the endless prattle on CAPE-Shiller valuations has obscured one of the most important features of post-2008 markets; namely, that the eventual increase in rates by the Federal Reserve in response to the economic recovery will likely be less than any time since the Great Depression.

Why? Because the Great Recession was severe and folks are forgetting that. They’re getting too fancy for their own good with expectations that the reversion to the mean could be swift and sizable.

It won’t be, and the bottom line is this: In some ways, indexing the core of a portfolio in accordance with your risk appetite is as sensible as it’s ever been. Don’t get too fancy with strategic allocations.

But as investors look for the best tactical overlay to help cushion portfolio volatility, they better be thinking clearly and taking true measure of what a credit-driven downturn can do to the macroeconomy in terms of damage and how long the healing can take.

Don’t expect recent history to repeat.

Disconnected From The New Reality

The problem is that many investment models, research and commentary are all stuck somewhere in the late 1990s.

Back then, the main story about the business cycle was based on the classic response to inflation expectations, and the market’s narrative was based on price expectations—as in expected returns over the next few years based on current valuations.

The real story—the one that adequately describes the macroeconomic situations in the U.S., Japan and the eurozone since the ’90s—is about interest rate and liquidity expectations, not price or inflation expectations.

Right now, this right-minded way of thinking is telling us that, almost eight years after the easing began and when the Federal Reserve’s tightening cycle comes to a conclusion, rates won’t look at all as they have in the past several decades.

In other words, rates will not come close to the 2.5 to 4 percent peak in the Fed Funds rate that has generally accompanied the end of a classic business cycle and inflationary pressures historically associated with the end of a bull market.

FOMC_Expectations

Sources: FOMC, JFG


 

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